Previously I shared the notes I took from Li Lu’s speech at Peking University in late November. It was an absolutely fantastic value investing session, one of the best I’ve ever heard. Some readers have asked whether the video is available somewhere on the internet. Unfortunately at this point, neither the video nor the transcripts are available anywhere. My guess is that in the future, the Chinese version of the transcript will be available.
Another reader asked whether it’s possible to know of this event in advance. Unfortunately, the answer is also no. Based on my knowledge, this was an unplanned event.
Li’s speech covered a variety of topics and he generously answered many questions. I’ll share the most important takeaways from his speech.
How to think about the relationship between margin of safety and circle of competence
The most surprising statement I heard from Li is that it’s acceptable to buy a company if it’s cheap enough, even if you don’t under the business. After a rigorous analysis of the balance sheet, if you can get comfortable with the legitimacy of the assets value, you can get enough downside protection if the market value is significantly below the net asset value. He mentioned the idea of ownership mentality after the purchase of the company’s securities. In other words, he bought the company first because it’s cheap enough, then he went out to build his circle of competence in the business by learning as much as possible about it, from an owner’s point of view.
I found this surprising because I had thought that circle of competence takes priority over margin of safety. Said another way, it’s more important to build a circle of competence than to merely rely on a balance sheet-based margin of safety.
After hearing Li’s lecture, I spent a lot of time thinking about the proper sequence of circle of competence and margin of safety. The issue with my previous thinking is that circle of competence itself is very hard to build and it’s very common to think you understand something when, in fact, you don’t. Very few can tell the edge of one’s circle of competence. Therefore, we should build a margin of safety within the circle of competence. In other words, we should be very conservative in estimating whether we truly understand a business or not. And if we acknowledge that we may very wrong in our judgment regarding our circle of competence, we should require a sufficient margin of safety to protect ourselves. Therefore, margin of safety should take priority over circle of competence.
As we all know, intrinsic value has two key components – asset value and earnings power. Li’s idea is that if you buy a profitable business with some sort of earnings power below the net asset value, you get the asset at a discount plus all the future earnings for free. And because predicting future earnings requires a deep understanding of the business, which investors often overestimate, it’s better to pay nothing for the growth. His investments in BYD Co. Ltd. (HKSE:01211, Financial) and Shanghai airports are classic examples of this way of thinking.
Overestimating my circle of competence has led me to build an earnings growth component in my intrinsic value calculation. But Li probably views earnings growth as downside protection. In BYD’s case, he bought the company as a net-net. He’ll make money as long as BYD doesn’t incur losses. For many the company's investors, its future earnings growth is part of the price they are willing to pay.
Buffett says it’s better to buy a wonderful business at a fair price than a fair business at a wonderful price. Li buys a wonderful business at a wonderful price. And he fishes in markets where such opportunities still exist.
The intellectual honesty system
In his lecture, Li explained why he rarely gives public speeches and why he doesn’t talk about his current investments. He says humans have a tendency to exaggerate one’s achievements when speaking publicly. If you are an eight out of 10, after speaking many times in public, you may think you are a 10 out of 10. This is human nature. Therefore, he tries to minimize public speaking to avoid self-exaggeration. Similarly, when you talk about an investment idea publicly, you are pounding it in subconsciously. It’s very hard to be intellectually honest if you keep pounding it in. So the best way is to prevent yourself from the commitment and consistency bias by not talking about your investments in public.
In the post-event gathering, a student asked Li a big idea question. Instead of answering him, the questioned the validity of the student's assumptions. The student realized that what Li was trying to teach him is to be more rigorous in reaching his conclusions. Instead of relying on your intuition, always use numbers and first-hand evidence to back up your conclusions. Keep challenging your assumptions and verify the validity of your evidence.
These are a few examples of how Li thinks about intellectual honesty. It’s a moral duty. He has built a system of minimizing anything that may cause human psychological biases. I can also tell that he is very rigorous about gathering data and evidence regarding any big hypothesis. In this way, he reminds me of Richard Feynman.
Read more here:
- Distorted Incentives: Why Less Is More
- Notes From Li Lu's Latest Speech at Peking University, Part 2
- Notes From Li Lu's Latest Speech at Peking University
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